How the Tax Cuts and Jobs Act Affects Real Estate Entities

On December 22, 2017, a new tax reform bill known as the Tax Cuts and Jobs Act (the “Act”) was signed into law. The Act will affect many taxpayers from businesses to individuals. This article will focus on how the new rules affect the various aspects of the real estate industry at an entity level.

Interest Expense

Real estate entities are mostly financed through mortgages and interest expense and has always been one of the larger deductions that was taken. Effective January 1, 2018, the Act generally limits the annual interest expense deduction to 30% of the adjusted taxable income for a trade or business with annual gross receipts exceeding $25,000,000. The adjusted taxable income of a business is computed without regard to any item of income, gain, deduction, or loss which is not allocable to a trade or business and by adding back (i) business interest expense or business interest income, (ii) net operating loss deduction, (iii) 20% deduction for pass-through income, and (iv) depreciation, amortization, or depletion for taxable years through December 31, 2021. Any interest expense not allowed, will be carried forward indefinitely by the entity unless it is a partnership. Any business interest that is not allowed as a deduction to the partnership for the taxable year is allocated to each partner as "excess business interest" in the partners’ non-separately stated taxable income or loss of the partnership.

Real estate entities may make an irrevocable election to take a 100% interest expense deduction. However, if the election is made, the entity must use the alternative depreciation system (ADS) for non-residential real property, residential real property and qualified improvement property (QIP).

Depreciation Expense

The Act modifies the bonus depreciation allowed for qualified depreciable personal properties. No bonus is allowed for personal property acquired prior to September 27, 2017 and entities are allowed 100% bonus of the qualified property acquired and placed in service after September 27, 2017 and before January 1, 2023. After that, it decreases by 20% each year resulting in no bonus in 2027.

Under MACRS, the depreciable life of non-residential real property and residential real property remains at 39 and 27.5 years, respectively. While, the depreciable life of QIP goes from 39 to 15 years beginning January 1, 2018. However, as mentioned above, if the entity makes an election to deduct 100% of interest expense, the entity must use ADS for non-residential real property, residential real property and QIP, which has recovery periods of 40, 30, and 20 years, respectively.

In addition, the Act increases the maximum amount a taxpayer may expense under section 179 expensing to $1,000,000 and increases the phase-out threshold amount to $2,500,000.

Net Operating Losses

The Act limits the amount of net operating loss (NOL) allowed in any taxable year to 80% of an entity’s taxable income with respect to losses arising in taxable years beginning January 1, 2018. Any unused NOL may be carried forward indefinitely. Moreover, the Act prohibits the carryback of NOLs effective for losses arising in taxable years beginning January 1, 2018.

Like Kind Exchanges

The Act retains the current section 1031 exchange rules for real property. However, it repeals the use of section 1031 for personal property and therefore will no longer qualify for the deferred tax treatment.

Most of the new rules are applicable to the tax years beginning 2018, and taxpayers should start planning for the 2018 tax year. There are many changes due to the new Act and it is important for all taxpayers to understand how all of this is going to affect them.

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